Thursday, October 31, 2013

Imagine the kids collecting themselves at home tonight, comparing their booty, and in the mix of treats, you find some home-made caramels or rice crispy treats, or some such. How would you react? I think many prudent parents would throw them out, these days. Even accepting that there is nothing to the fear mongering about needles in apples or poisoned candies, do we know what the ingredients are in those treats? Do we know if the kitchen was thoroughly cleaned and disinfected? No, the prudent parent in this day and age says, "You can only eat candy that was produced and sealed up thousands of miles away, by some portion of hundreds of workers, anonymous to you, working solely in their own self interest for the purpose of earning wages or a profit." (edit: Well, probably not in those exact words....)

In our private lives, when it comes to things most precious to us, we become extremists in our esteem for Adam Smith's cold and calculating butcher, brewer, and baker.

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I was working on some complex excel spreadsheets this morning that I have created in order to interpret the Eurodollar futures market. As I do every day, I input the day's range of settled prices across contracts, and hit that magic little button labeled "Solver". Excel performed calculations in a few seconds that would have taken me days to do by hand, maybe weeks, and spit out an interpretation, per my specifications. This program has easily provided me with $10,000s of consumer surplus. Over my life, it will likely provide consumer surplus in the millions of dollars. The producer surplus captured by Bill Gates and the other owners of Microsoft can't be more than $20 or $30. The imbalance there is cosmic. Bill Gates should be pissed. I should be embarrassed to accept a deal with such overwhelmingly unfair terms.

Yet, the absurdity of the situation is even more outrageous than that, as there are many who claim that it is Mr. Gates' claim on that paltry $30 profit that is unjust - and capitalism is blamed for the imbalance that appears by comparing Mr. Gate's accumulation of $30 gains to the lack of profits claimed by some people who happened not to engage in the mutually beneficial trade shared by Mr. Gates and me.

I can agree that a complex web of network effects and a certain amount of luck in the timing and process of developing computer standardization might have made Mr. Gate's profits larger than they might otherwise have been, in a sort of winner-takes-all business context. But, the irony, of course, is that the relatively unfettered process of competitive production is what brought Mr. Gate's large take down by orders of magnitude lower than the benefit to consumers like me. And, the process that allows us to imagine a world without Mr. Gates, that ends up with a very similar product at a very similar price, with someone else pocketing the producer surplus, is a process uniquely created through the redundant, anarchic, and competitive landscape of the capitalist market system.

The infamous strawman of perfectly competitive markets that many suppose underlies the defense of markets is only within the grasp of our imagination because actual markets come so close to achieving it.

Tuesday, October 29, 2013

Tyler Cowen linked to two pieces on asset prices from Bordo and Landon-Lane looking at asset prices in relation to monetary policy, which got me thinking more about home prices. Here is a simple chart I put together to help visualize the relationship.

The pieces linked by Tyler seem misguided to me. It looks to me like the core idea is a tautology - that the market value of assets move inversely to interest rates. Then, they attribute the movements in those interest rates to monetary policy, with low rates reflecting loose policy and vice versa.

This seems dangerous to me. Durable assets should have a strong inverse reaction to real long term interest rates. But, these rates are not dependably related to monetary policy. To the extent that durable assets act as inflation hedges, a loose monetary policy could reduce their real value by changing the skew of the inflation risk. And, as I have pointed out with the housing market, inflation can reduce home prices by decreasing demand through high nominal mortgage rates.

The dangerous part is that if rates are low, not because of short term central bank maneuvers, but because of a lack of investment demand or some other structural economic problem, then calls for central banks to tighten monetary policy as a reaction to low rates/high asset prices, would be needlessly damaging. In fact, it appears as though this is what happened in 2007-2008.

The lowest inflation and NGDP growth rates in the 1970's were higher than the peaks in the 2000's. Isn't it clear that the low real rates and high asset prices, at least in the 2000's, are driven by something other than loose monetary policy?

Monday, October 28, 2013

This is a follow up to this post, and other previous posts on the topic.

I would also challenge the causality of the subsequent crisis. I learned this from Scott Sumner, although I won't attribute it to him, in case I've gotten a detail wrong in my own interpretation of it that he would not agree with....

Common Interpretation

1) Low short term rates (from loose money)

2) Banking Bubble

3) Housing Bubble

4) Housing Bubble Bursts

5) Fed cuts rates in 2007-2008 in heroic ﻿attempt to throw more loose money at the problem

I would say that this is totally wrong, but there are just too many subtle interpretive changes required, and the change in the paradigm caused by those interpretive changes is so marked, that it would be a difficult change for a reasonable observer to accept without some strong social support.

I don't mean to use some broad hypothetical psychoanalysis to dismiss all reactions against my interpretation. I may seem wrong because I am actually wrong. But, if I'm on to something, I don't think it's an argument that can be easily reasoned through.

In any case:

My Interpretation

1) Low long term inflation expectations (from tight money) together with low long term real rates.

2) Housing Boom (not bubble)

3) Banking Bubble (from a combination of the housing boom and regulatory issues)

4) Short term rates decline due to manageable declining demand, possibly assisted by home prices which were declining (still behaving reasonably in relation to long term rates)

5) Fed follows short term rates down, creating the image of loose monetary policy even though liquidity problems in the financial sector and a stagnant monetary base indicated very tight monetary policy.

6) Money becomes so tight that the economy collapses in a liquidity crisis in 2008

7) As a result of such low nominal rates, the Fed loses much of the leverage of conventional monetary policy mechanisms because there is little to no incentive to spend or lend cash that the Fed releases into the economy through bond purchases. The large amount of bank reserves this creates continues to create a false impression of loose monetary policy even though policy continues to be fairly tight.

8) Housing boom re-ignites in the aftermath of the crisis, even as credit conditions remain tight, because the original context of low real rates and low inflation expectations remains in place.

I'm afraid that we will see #9) Fed tightens money supply in a misguided attempt to avoid a new housing bubble, causing real incomes to fall again.

Adam Ozimek at Modeled Behavior cites this new NBER paper from Will Dobbie and Roland Fryer that shows very positive outcomes for lottery winners in the Harlem Children's Zone charter school program.

Ozimek points out that the lottery winners not only saw large increases in test scores, but they also showed improvements in other quality of life measures.

I think the statistical measures from the study actually understate the improvements, because they are carefully controlling for sample size, response rate variations, etc. But, the raw data is overwhelming. From page 17 of the study:

Seventeen percent of female lottery losers report having been pregnant at some point...... Female lottery winners are 12.1 (4.6) percentage points less likely to report that they have ever been pregnant, a 71 percent reduction from the control mean.......

Four percent of male lottery losers were incarcerated during our sample period, compared to none of the male lottery winners.

The authors note that this is a high-achieving charter school, and that some evidence shows that typical charter schools don't outperform typical public schools on test results. But, the more important factor is the effect from the right to exit on ongoing innovation and administration. Imagine all the pressures there are to improve the Harlem public schools. Public schools across the country are responding to calls for improvement. And, underperforming charter schools are simply closing. Compare that to the circus of self-interested advocacy that surrounds underperforming public schools. This is a subtle distinction that is counter-intuitive: Q: Has the charter school movement been successful? A: Yes! Just look how many have closed!

Ozimek also makes the following point:

If these results were found for a particular high-performing pre-k program then the response by reform critics would be that we need to figure out how to increase access to high-performing programs like this, and not too minimize it by pointing to less impressive average program impacts and the difficulty of replicability. The difference is that universal pre-k would represent mostly new government spending and an opportunity for expanding the public sector workforce, while high-performing charters in the long-run are more likely to crowd out existing public sector workers and spending.

Scott Sumner and ArnoldKling have reacted to this post, where I tried to offer numerical evidence that the housing boom was not a bubble. Scott seems to generally like the idea. Arnold pushed back with some good points. Here is the text from his second post:

Certainly, reducing the down payment requirement does not cause market interest rates to be lower. So between those two variables, causality can run at most in one direction.
You are saying that the real estate industry is not going to push for lowering the down payment requirement in a high interest-rate environment. I can see that if the marginal homebuyer is low on income and low on assets. If nominal interest rates are high, the monthly payment will be daunting, and lowering the down payment requirement cannot help this person.
On the other hand, suppose that the marginal homebuyer has decent income and low assets. Even in a high interest-rate environment, lowering the down payment requirement might help that person. And if interest rates are high because of general inflation, including house price inflation, then from the bank’s point of view it is safer to lower the down payment requirement in this environment than in an environment of low inflation.
I think that the main reason that down payment requirements went down was because the people lending the money at least implicitly assumed rising house prices. In addition, government officials were beating up on lenders for rejecting applicants from what was called the “under-served” segment of the market. (Of course, by 2010, government officials described this segment as “borrowers who were not qualified” and were shocked, shocked that the evil, predatory lenders had forced these people to take loans that they could not repay.)

These are good points. He had commented that aggressive financing methods like low down payments had pushed home prices up. I responded that the causation went the other way. Low long term interest rates caused housing prices to go up and also created pressure for reduced down payments.

The reinterpretation I am suggesting reverses the causation at another level also. There was a AAA-rated securities bubble within the banking sector and, separately, a housing boom.

I think the conventional version of the causality says that low short term rates ("loose money") caused the banking bubble which caused a housing bubble. I am proposing that low long term rates ("tight money") caused a housing boom (not a bubble) which fed a banking bubble in AAA-rated securities.

My main point is that homes are like very long term TIPS bonds. Real rates, even at the long end of the yield curve had decreased by several percentage points over the previous 25 years. A reduction of 3% in long term real interest rates could justify an increase in home prices of 50% or more. This factor alone can explain most or all of the rise in home prices. An excess of aggressive financing might have added some froth at the end, but this factor is not necessary to justify the general price movements we saw.

The accumulation of equity among homeowners and the new subsets of the population who could qualify for mortgages because of low monthly payments were reasonable outgrowths of the boom. The bubble in banking was the result of institutionally rigid rule sets which regulated banking activity. Pressures to increase exposure to subprime lending, static rules regarding leverage of this credit, and legal protections for bank creditors were the pathogens, and all this new housing equity was the agar.

1) So, largely exogenous factors led to low long term real rates, which, combined with low inflation due to longstanding Fed money supply policy, led to a sharp increase in home prices.

2) High home prices, together with an unfortunate combination of public banking policies, led to a banking bubble.

3) The Fed countered the banking bubble with even tighter monetary policy, which created a credit crisis that brought down the banks and the housing boom.

4) Because the basic ingredients for increased home prices are still in place, we are now seeing a renewed increase in home prices. This is happening in the face of credit markets that are still hobbled. But, the power of low real and nominal rates regarding home prices is so strong that home prices have stabilized and begun to rise again at elevated levels even though a large share of home purchases are from all-cash investors, due to the credit crisis. This is kind of the opposite of the case from the 1970's that Arnold mentioned, where a low-asset, high-income household might have been willing to lower their down payment in the 1970's in order to establish home ownership. Now we have banks that are incapable of loaning to a large number of home-buyers, even though the interest rate context would attract them. So, private equity investors with their own sources of cash are stepping into the market.

The sad irony is that, on the margin, loose monetary policy in the 1970's kept home prices from rising to the levels we saw in the 2000's. But, public sentiment is going to pressure the Fed to tighten money again as home prices continue to rise. Tight monetary policy can lower inflation, and at the extreme, lower real incomes, like it did in 2008. Since lower inflation will only increase real home prices by lowering nominal mortgage rates, if the Fed becomes determined to knock down home prices, it will have to tighten again to the point of damaging real incomes. That would be unfortunate.

This is one of the many issues where we tend to get selective amnesia in defense of our political biases. Conservatives forgot about noisy data and seasonal fluctuations when they saw a data point that looked like it was a negative consequence of Obamacare. Liberals forgot about how they normally model the employment market as if employers hold all the power when they argued that the employment market was basically unchanged in the face of a clear incentive for employers to demand that change.

I consider Obamacare to be a law that will have many negative consequences, seen and unseen, and some of those consequences will be visible in the labor market. But, an immediate and sizable transfer of labor from full time to part time is not one of them - at least not yet. If it does happen, it will probably happen slowly, because in the infinitely complex market between laborers and employers, laborers have a strong influence on the equilibrium state.

If the government simply outlawed part time labor, we would see an immediate and significant change in the make-up of the labor force. That is because the government can force change that doesn't account for the infinitely complex set of demands and negotiations between laborers and employers. The fact that government can force change so effectively is exactly the reason why it is so destructive. Much of the health care mess we have today results from the government instituting controls on cash wages in WW II very effectively, and then enforcing the employers' health insurance tax benefit very effectively for the next 80 years. Obamacare intends to fix the resulting problems with hundreds of fines, fees, obligations, price controls, and mandates, each of which will be enforced very effectively.

There was an old lady who swallowed a fly......

PS. On the employment report itself, I believe that this is a continuation of the state of affairs where the unemployment rate is the most telling part of the report, but everyone brushes it aside because they are misinterpreting the declining level of labor force participation. In the short term, this appears to be tricking the Fed into keeping a looser monetary policy through extended QE3, since they continue to overestimate future GDP growth while under-forecasting the decline in unemployment. It looks to me like unemployment will be at 7.0% before they even begin tapering. In the end, though, I fear that the Fed will continue to be too focused on inflation. The continued flow of baby boomers out of the labor force probably calls for a slightly higher inflation target, which the Fed will not follow, and I'm afraid that we will be back at the zero bound after the recovery slows down. If we see an uptick in growth and suddenly find ourselves at the beginning of 2015 with 6.0% unemployment, strong home prices, and a surge in inflation, I'm afraid the Fed will whipsaw us back into another liquidity crisis.

Saturday, October 19, 2013

Scott Sumner asked me to take another look at this. I've graphed the relationships again, categorized according to Euro membership. The Euro group includes Denmark, per Mark Sadowski's comment at TheMoneyIllusion. For my graphs, the entire set consists of the OECD countries, from IMF data. (ex. Estonia because of incomplete data)

The results look to me like they fit Scott's expectations.

On the consolidation vs. growth relationship, the R-squared for non-Euro countries is .0175. The four non-Euro countries in the lower right quadrant are Great Britain, Iceland, Hungary, and the Czech Republic.

On the initial structural balance and growth, there is a similar positive relationship with both Euro and non-Euro countries. The correlation is much stronger for the Euro countries.

On both relationships, the intercept growth rate for the Euro countries is 2% lower than for the non-Euro countries. This is the average growth rate over 4 years, so after accounting for either consolidation or structural balance, the Euro countries have lost 8% in economic activity compared to the rest of the developed world.

ex Greece

If we treat Greece as an outlier, then the R-squared values for the Euro countries decline in both relationships. The Euro countries still have a 2% lower growth rate compared to non-Euro countries.

Fiscal policy does not have a statistically significant correlation with growth in the non-Euro countries. The annual growth coefficient of -.1422 for the Euro countries implies a multiplier of .56.

This appears to confirm Scott's point of view:

ex Greece

1) Since the monetary authority is the last mover, it neutralizes fiscal policy. Countries that don't share a monetary policy should not experience any predictable effect from fiscal budget policy. And they don't here.

2) The Euro countries could individually experience a relationship between fiscal policy and growth because they share a monetary policy, which doesn't allow monetary policy to counteract each country's fiscal policy. This is also what we find here, although the coefficient (ex. Greece) is only .56 (.14 x 4), which is quite weak. If we include Greece, then both fiscal consolidation and the initial structural balance have strong correlations with economic growth, with p-values well under .01.

3) Tighter monetary policy regarding the Euro would lead to lower NGDP growth. That is also what we find across the board here. The Euro area has lower growth across these comparisons of about 2% per year over 4 years - presumably, at least in part, due to tighter monetary policy.

It is also interesting to revisit the relationship between the starting structural balance and the subsequent fiscal consolidation. For the entire set of countries, R-squared is .60 while the coefficient is -.63. When we separate the data by Euro affiliation, we see that the relationship comes mostly from the Euro countries. And, here, the removal of the Greece outlier doesn't affect the relationship very much.

Conclusion

This looks like strong evidence to me of the primary power of monetary policy during the crisis years. For countries with independent monetary policy, there are very weak relationships between fiscal policy and economic growth during 2008-2012. Countries with positive structural balances before the crisis tended to have less fiscal consolidation (p value = .045) and higher growth (p value = .065), but, interestingly, fiscal consolidation itself does not have a statistically significant correlation with economic growth for these countries. This suggests that fiscal policy could be managed for its own sake in these countries, and was largely overshadowed by other factors, monetary policy presumably being a large and controllable one.

For the Euro countries, there was a very strong correlation between the 2008 structural balance and subsequent consolidation (p value ~0, even ex Greece). The 2008 structural balance had a weaker correlation with subsequent growth (p value = .12, ex Greece), but consolidation had a stronger negative correlation with growth (p value = .085, ex Greece). European policies forced countries to correct their structural imbalances, and their lack of control over monetary policy meant that fiscal consolidation was felt in lower growth.

In addition, annual NGDP growth across the Euro countries was about 2% lower over these years. As Scott would say, this is the measure of monetary policy. Looser monetary policy would have raised NGDP across the Euro countries. They would have still shared a unique susceptibility to fiscal policy, but positive effects of looser money might have reduced the need for consolidation.

Friday, October 11, 2013

I believe that it is generally taken as a given that there has been a persistent level of higher returns from small cap stocks, compared to large caps, but that this higher return is at least partially explained by higher volatility among small caps, so that the risk/reward profile for small cap stocks, measured by something like the Sharpe Ratio, is not as high as the raw returns would suggest.

Normally, in a portfolio, this distinction would be handled by matching the portfolio holding period to the risk profile of the available asset classes. A portfolio with a longer holding period would be better able to capture the higher returns of small cap stocks because as the holding period increases, the benefit of the higher returns increasingly outweighs the cost of volatility. If I am investing cash that I need to withdrawal in 60 days, I might expect small cap stocks to give me an average return of 2%, compared to 0% in risk free bonds. So, the possibility of taking a 20% hit due to unforeseen volatility is not worth the risk. However, over 20 years, small caps might be expected to give a 1000% return, compared to 100% for risk free bonds. Over that time period, the small caps would still provide much higher returns, even if we happen to withdraw the funds during a 20% downturn.

But, I noticed something interesting, at least for the period over the 25 years. I was looking at this chart:

The Russell 2000 is in red and the S&P 500 is in blue. We see the slightly higher return over time from the small cap index (although, the S&P 500 makes up for this with a higher dividend). But, eyeballing it, the Russell 2000 index looks like it might be the less volatile of the two indexes.

So, over the past 25 years, I compared the 2 indexes based on standard deviation of prices over 1 month, 1 year, 2 years, and 5 years. This is what I found:

Over shorter holding periods, the volatility of the small cap stocks is higher than the large cap stocks, as we would expect. But, as the holding period extends to 2 years or 5 years, the volatility of the Russell 2000 declines. For the 5 year period, this only includes 5 data points, but the effect appears to be unaffected by the starting points of the holding periods.

If I annualize the volatility, the S&P 500 appears to have a fairly flat profile, indicating some positive serial correlation over periods less than 2 years, but generally a low level of serial dependence. For small caps, on the other hand, there appears to be a large amount of very short term volatility, but even at short holding periods, reversion to the mean causes volatility to decline as the holding period increases.

Small caps would appear to provide better opportunities across the time profile. For the short term speculator, they provide greater volatility. For the long term investor, they provide comparable or superior return performance with significantly less volatility. Across the board, small caps appear to offer superior performance for investors who are not subject to non-financial risks (such as reputational and agency issues).

Tuesday, October 8, 2013

1) At the core of human social intuition is a Puritan discomfort with free lunches.

2) It's not that we think there are free lunches; it's that we are satisfied that someone is paying. The potlatch creates status much more powerfully than the marketplace, pillage even more so. The highest status of all? Pillaging those who appear to be high status themselves.

Saturday, October 5, 2013

First, Menzie Chinn at Econbrowser discussed the estimated fiscal drag of the shutdown here. He measures the drag on GDP based on foregone federal payrolls. He mentions that multipliers will make this drag even larger, but notes that if the government employees receive back pay, the damage will be mitigated.

This exposes an important distinction between the private economy and public expenditures. The monetary value of voluntary private transactions can be presumed to generally reflect the minimum value of the transactions. But, we account for public expenditures the same way, even though with public expenditures this presumption can't be made.

You might notice that the one thing he doesn't concern himself with is whether those federal employees are doing anything useful. In fact, by noting that back pay would mitigate the damage he is explicitly arguing that what they produce is not important.

He may be right that the measure of GDP will be affected by the shutdown. But, to the extent that he is right in this analysis, GDP is a completely useless measure. This kind of decline in GDP would have no bearing on our standard of living, and I'm not even sure if it would have much of an effect on asset markets, interest rates, etc. In essence, this argument (and it seems to be a common argument) says that taking money from one citizen and giving it to another in the private economy is not production (GDP doesn't grow when you win a bet), but if the same transfer is made as a public expenditure it is production. In fact, with multipliers the production is presumed to be even more than the amount of the transfer.

This seems especially wrong in this case, where I think this would more reasonably be treated as an unexpected one-time tax on federal employees. I believe that the evidence shows that this kind of tax would provide federal revenue without creating the kinds of deadweight loss that other taxes generally create. The federal employees will not change their spending habits, but will decrease their savings in response to the one-time tax, so that consumption will not decrease markedly. And they will eventually compensate for this by working more to reestablish their lost wealth, creating GDP growth.

Further, as Scott Sumner would argue, the multiplier is actually near zero because of monetary offset. And the Fed seems to be extending QE3 as a result of these fiscal difficulties. So, let's say the Fed is adding monetary stimulus because of these Keynesian ideas about public expenditures; and let's say that the shutdown is actually a stimulative one-time tax on some federal employees. The Republicans may have actually found a way to trick the Fed into finally being as stimulative as they should be. Let's have a shutdown for a few more months! The next published unemployment report will be in December, with reported unemployment coming in at 6.7%, and we'll be dancing in the streets!

The second item was a discussion I heard on NPR about the medical device tax, which the Republicans are making a part of the shutdown issue (here's a depressing earlier story). The debate was framed as an argument between those who want the tax in order to make Obamacare revenue neutral and those who want to negate the tax because it will hurt the medical device industry.

The only winner in that debate are influence peddlers. And the loser is everyone else. That is the outcome regardless of what the practical result of the debate is.

The actual debate should be between having transparent, fair, minimal taxes and having opaque, arbitrary, targeted taxes. But that's not a fair debate. The former is the unalloyed winner of the debate in principle, and Obamacare is 10,000 pages of the latter. The public exchanges have just opened up and it looks like we are building up to a vote on the medical device tax that will break bi-partisan, based on which Congressional members count medical device manufacturers as supplicants. Who says this is a do-nothing Congress?